In the last decade, lower interest rates and market forces made it easy for investors to drive returns. But is the heyday of passive investing now history?

In the last 10 years, sustained monetary stimulus—lower interest rates aimed at keeping economies afloat after the global financial crisis—made it easier for investors to earn returns in fixed income. Simply being invested in the bond market was enough to earn decent returns. That's all changed in this new era of rising interest rates.

In this environment, where market beta adds little value or even detracts from returns, it becomes fundamentally important to tap into other return sources.

Today, markets have mostly normalized, and it is no longer enough to just be in the market. Making active choices around duration, credit and yield curve positioning is more important than ever, and getting it wrong can lead to missed opportunities and potential losses.

Bottom line: We’re now in a strategy shift from simple market exposure (beta) to the need for in-depth analysis of individual bonds and market segments (alpha) to help drive returns and create diversification benefits from owning fixed income.

The Beta Avalanche is Ending

The era of beta dominance actually goes back much further than the financial crisis of 2007-2008. For close to four decades, declining yields have been a primary support for fixed income returns. In fact, from 1989-2017, the Bloomberg Barclays U.S. Aggregate Bond Index averaged a 6.4% annual return. Of that, 95% was derived from duration, the beta effect of falling yields across fixed income markets.1

So the shift from beta to alpha as the dominant driver of returns truly marks the beginning of a new era in fixed income. By early 2018, most major central banks had either ended or were starting to end their stimulative monetary programs. By comparing index returns so far this year to those during the 10 years of monetary stimulus (2008-2017), we see a new era unfolding: The cessation of stimulus has slowed down the beta engine that had fueled returns in earlier years. In other words, just being in the market is no longer enough.

The End of Stimulus Marks a New Era in Fixed Income

Source: Morgan Stanley Investment Management. Data as of 3/31/2018.2

Fixed Income as a Diversifier

As the shift to alpha-driven returns unfolds, investors may be tempted to question the validity of bonds as diversifiers. Some research shows that negative stock-bond correlations, which are suggestive of strong diversification benefits, are associated with accommodative monetary policy.3 Given that the era of accommodative monetary policy is nearing an end, it would be logical for investors to question the diversification benefits of fixed income going forward.

Our answer at Morgan Stanley Investment Management, unequivocally, is that bonds will continue to play a vital role in portfolio diversification—both in the new era and throughout changing market cycles for many years to come. However, one of the biggest challenges will now be to manage interest-rate risk when there is virtually no yield cushion to buffer the effects of rising rates.

In the precrisis period, when interest rates were higher—and even going back as far as the 1980s—a generic allocation to investment grade fixed income provided both return and diversification properties because bond yields were much higher. In the 1990s, for example, an investor could buy A-rated corporate bonds with yields averaging over 7%. Such bonds could absorb an approximately 130-basis point rise in U.S. Treasury yields before incurring an absolute return loss. That sort of yield cushion does not exist today. In fact, a rise of just over 50 basis points in U.S. Treasury yields could trigger an absolute return loss in today’s market, all else being equal.

We are not suggesting that yields are going to spike higher anytime soon, but we are suggesting that we are near an inflection point. As we see it, the secular decline in yields is coming to an end, and bond yields may bounce along the bottom and trend higher in the years to come.

Shift Requires Change in Strategy

In this environment, where market beta adds little value or even detracts from returns, it becomes fundamentally important to tap into other return sources.

This is where investors need to make choices, and there is a spectrum of strategies from which to choose. Indexed strategies generally rely heavily on beta as a source of returns. Nonindexed strategies have the potential to also generate alpha through in-depth analysis on duration, sectors, credit spreads and yield curve structure.

In our view, only by taking advantage of these more idiosyncratic opportunities in global markets can investors achieve alpha. Given today’s market conditions, we think that returns from alpha-oriented decisions have the potential to exceed returns from simple market exposure.

The Right Alpha Producing Conditions

That said, alpha is a scarce commodity. In the current environment, some large asset managers may likely struggle to generate alpha because they may not be able to secure enough individual bonds to fill their needs. To compensate, they may frequently rely on derivatives to gain synthetic exposure. These derivatives usually behave like indexes and thus are largely beta-driven, defeating the purpose of active alpha-seeking strategies. Reliance on derivatives can also be costly, and it is no substitute for a durable portfolio of actual securities.

In general, we advocate owning a bond fund over individual bonds because it reduces concentration risk. The reason is that a fund has the advantage of diversification across a wide range of sectors. It is difficult to replicate these diversification benefits by owning a series of individual bonds or a ladder strategy, which holds individual bonds of different maturities.

A New Era Requires a Focus on Alpha

This new era requires a new mindset in our opinion. More than ever, investors will need to explore alpha focused strategies in an effort to achieve competitive performance. These strategies should be overseen by skilled active managers who have the latitude to dynamically adjust their portfolios in an effort to extract value from duration positioning, credit analysis, yield curve exposure and security selection. The choices fixed income investors make today will have significant implications for performance and diversification benefits going forward.

Adapted from the Investment Insight “Built for Change: Shifting from Beta to Alpha." For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas.

Risk Considerations

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging-market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

1 Data from Bloomberg Barclays U.S. Aggregate Bond Index (1989-2017)

2 The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. <b>Past performance is no guarantee of future results.</b> Returns for less than one year are cumulative (not annualized). See Disclosure section for Risk Considerations and index definitions. Investing involves risks including the possible loss of principal. In general, fixed income investments are subject to credit and interest rate risks. High yield investments may have a higher degree of credit and liquidity risk. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than investments in foreign developed countries. Investors should carefully review the risks of each asset class prior to investing

4 The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions. Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.

INDEX DEFINITIONS

The Bloomberg Barclays Euro Aggregate Corporate Index (European Investment Grade) is an index designed to reflect the performance of the euro-denominated investment-grade corporate bond market.

The Bloomberg Barclays Global High Yield Corporate Index (Global High Yield) is a multi-currency measure of the global high yield corporate debt market. The benchmark name changed from Barclays Global High Yield – Corporate Index to Bloomberg Barclays Global High Yield – Corporate Index on 24 August 2016.

JP Morgan Global Government Bond Index (Global Government Bonds) is a market value weighted fixed income index comprised of government bonds in developed countries.

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results. The returns referred to in the commentary are those of representative indices and are not meant to depict the performance of a specific investment.

The views, opinions, forecasts and estimates expressed of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market, economic or other conditions. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

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